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IRS Clarifies Taxes on Cryptocurrency Hard Forks and Airdrops by Lewis Taub, CPA

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Posted on July 07, 2021 by Lewis Taub

Signaling that cryptocurrency is not a passing fad, more than 12,000 people gathered in Miami in early June 2021 for what was billed as the largest Bitcoin conference in history. As digital currency continues to gain mainstream popularity — both as a viable investment vehicle and a method of payment for goods and services — the IRS has stepped up its efforts to regulate crypto assets and enforce taxpayers’ virtual currency reporting and tax payment obligations. Most recently, the IRS addressed the tax treatment of “hard forks” and “airdrops.”

What are Forks and Airdrops?

In the simplest terms, a cryptocurrency fork is an update, be it a minor improvement or major change, to the blockchain protocols on which virtual currency transactions are recorded. With a hard fork, a blockchain coin/token permanently splits into two, leaving investors with two differently valued, incompatible types of blockchains and “tokens”: 1) the legacy cryptocurrency that continue to be recorded the original blockchain ledger, and 2) a new form of cryptocurrency with a new value to record on a new ledger under new rules. One of the most noted examples of a hard fork occurred in 2017 with the creation of Bitcoin Cash, a new and different form of currency from the original Bitcoin Blockchain. Subsequent hard forks have resulted in the creation of Bitcoin Private, Super Bitcoin, Bitcoin Gold and more.

An airdrop is a form of cryptocurrency marketing in which a developer distributes new tokens to potential users and investors, often for free, to generate attention and build a loyal base of followers.

How Does the IRS Treat Hard Forks and Air Drops?

In 2019, the IRS held in Revenue Ruling 2019-24 that hard forks and airdrops are taxable events for which recipients must treat the newly received cryptocurrency as ordinary income, even though they did not have any control over the fork and did not intentionally plan for or purchase the new coins. The recipient’s basis in the newly acquired cryptocurrency is the fair market value of the property when it is received. However, crypto users and the exchanges on which they are traded have argued that no tax should be owed until the holder disposes of the cryptocurrency, at which time taxes would be due on the resulting gain.

Two years later, the IRS Office of Chief Counsel on March 22, 2021, issued a memorandum concerning the Aug. 1, 2017, Bitcoin/Bitcoin Cash hard fork and the timing of when taxpayers must recognize the tokens they receive for income-tax purposes. More specifically, the IRS noted that taxpayers must recognize the fair market value of crypto tokens they “actually and constructively” receive from a hard fork or airdrop on the date they receive “dominion and control” over those assets as evidenced by the taxpayers’ ability to immediately sell, exchange or transfer the new token. Therefore, Bitcoin users would have had to recognize ordinary income equal to the fair market value of the new Bitcoin cash coins on Aug. 1, 2017, the date of the hard fork.

By contrast, taxpayers who use an exchange, such as Coinbase or CEX, to gain access to their cryptocurrency may not have received full control over the new currency for several days, weeks or even a year. Under those circumstances, taxpayers would wait to recognize income at the point that they can access, sell, transfer or exchange the new currency. Consequently, if the value of new tokens increased between the date of the hard fork and the date the taxpayer gained control over them, the taxpayer would recognize a higher amount of income at the later date of control and dominion.

Considering the general volatility of cryptocurrency, the amount of taxable income a user would report at the time of control and dominion could be significant. This is an especially critical consideration for taxpayers and cryptocurrency users in the current environment of rising tax rates under the Biden administration.

For example, profits from the sale or exchange of cryptocurrency are subject to capital gains tax, which is currently assessed at a top rate of 20 percent for coins held longer than 12 months. However, under President Biden’s tax plan, the top long-term capital gains rate would increase to 39.6 percent (plus the 3.8 percent Medicare tax) for individual taxpayers with annual income of more than $1 million. For those investors sitting on large quantities of cryptocurrency, consideration may be given to sell off their coins now to avoid exposure to nearly twice as much capital gains tax in the future.

The taxation of cryptocurrency is rife with technical issues that the advisors and accountants with Berkowitz Pollack Brant can help taxpayers navigate to properly report all transactions, including forks and airdrops, and minimize their tax implications.

About the Author: Lewis Taub, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he works with entrepreneurial business, multinational and multi-state corporations on tax planning and compliance strategies, including those related to mergers and acquisitions, basis issues and debt restructuring. He can be reached at the CPA firm’s New York City office (646) 213-7600 or info@bpbcpa.com.